1. Accounting The Make up of Costs
Dr Clive Vlieland-Boddy 1

2. The Functions of Management
Strategy
Evaluation
Forecasting
Planning – Choosing goals and deciding how to achieve them
Acting – carry out plan
Controlling – evaluating results by comparing the actual results to the plan.
You work for Baskin Robins – one of its goals is to increase operating income
How do you do it?
Incr sales price
Incr sales volume
Lower costs
The accounting system, by tracking costs, helps managers evaluate performance
Feedback

3. Summary of Objectives
Behavior – how costs react to changes in underlying cost driver
Variable or Fixed
Function – related to production or sales
Product or Period
Product costs –
Direct Material
Direct Labor
Factory Overhead
Traceability (cost of tracing cost to a cost driver directly should be lower than the benefits.
Managers need to rely upon different classifications of costs for different purposes. The four main purposes emphasized in this chapter include preparing external financial reports, predicting cost behavior, assigning costs to cost objects, and making business decisions. Our initial focus is on manufacturing companies since their basic activities include most of the activities found in other types of business organizations. Nonetheless, many of the concepts developed here apply to diverse organizations.

4. Costs
Anything incurred during the production of the good or service to get the output into the hands of the customer
The customer could be the public (the final consumer) or another business
Controlling costs is essential to business success
Not always easy to pin down where costs are arising!

5. Cost
A cost may be defined as a sacrifice or giving up of resources for a particular purpose.
Costs are frequently measured by the monetary units that must be paid for goods and services.
Costs are different from expense

6. Direct Vs Indirect Costs
Direct / Indirect costs
Direct costs
Direct labor
Direct materials
Whether the cost can be directly allocated to a given product
Indirect costs (overheads)
Managing director’s salary
Rent rates
Administration expenditure

7. Cost Concepts for Decision Making
A relevant cost is a cost that differs between alternatives. 1 2

8. Relevant Costs
Relevant
Irrelevant

9. Identifying Relevant Costs
Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs.
They are costs that will be incurred and can be traced to the product or process.

10. Product Cost
Product cost is the traceable costs that are attributable to a product or process.
Calculations under any costing system will include be the Actual Cost.
Do a quick example.

11. Non-manufacturing Costs
Marketing or Selling Costs
Costs necessary to get the order and deliver the product.
Administrative Costs
All executive, organizational, and clerical costs.
A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes most of these other costs are typically classified as marketing or selling costs and administrative costs. These costs are also called selling, general and administrative costs. Marketing and administrative costs are incurred in both manufacturing and merchandising firms.
Marketing costs include all costs necessary to secure customer orders and get the finished product into the hands of the customer. These costs are also referred to as order-getting and order-filling costs.
Administrative costs include all executive, organizational, and clerical costs associated with the general management of an organization that are not classified as production or marketing costs.

12. Product Costs Vs Period Costs
Product costs include direct materials, direct labor, and manufacturing overhead.
Period costs include all marketing or selling costs and administrative costs.
Inventory
Cost of Good Sold
Expense
Sale
Costs can also be classified as period or product costs.
Product costs include all the costs that are involved in acquiring or making a product. More specifically, it includes direct materials, direct labor, and manufacturing overhead. Consistent with the matching principle product costs are recognized as expenses when the products are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs.
Period costs include all marketing or selling costs and administrative costs. These costs are expensed on the income statement in the period incurred. All selling and administrative costs are typically considered to be period costs. The usual rules of accrual accounting apply to period costs. For example, administrative salary costs are “incurred” when they are earned by the employees and not necessarily when they are paid to employees. Period costs are non-inventoriable costs.
Income Statement
Income Statement
Balance Sheet

13. Manufacturing Cost Flows
Income Statement Expenses
Balance Sheet Costs Inventories
Material Purchases
Raw Materials
Manufacturing Overhead
Work in Process
Direct Labor
Finished Goods
Cost of Goods Sold
Part I
All raw materials, work in process, and unsold finished goods at the end of the period are shown as inventoriable costs in the asset section of the balance sheet.
Part II
As finished goods are sold, their costs are transferred to cost of goods sold on the income statement.
Part III
Selling and administrative expenses are not involved in making the product; therefore, they are treated as period costs and reported on the income statement for the period the cost is incurred.
Selling and Administrative
Period Costs

14. Product Cost Flows
To determine cost of goods sold as well as inventories, it is important to understand the flow of product costs. Raw material purchases made during the period are added to beginning raw materials inventory. The ending raw materials inventory is deducted to arrive at the raw materials used in production. As items are removed from the raw materials inventory and placed into the production process, they are called either direct or indirect materials. Indirect material costs are accumulated under manufacturing or factory overhead control account.

15. General Cost Terms Manufacturing Costs Direct materials Direct labor
Mfg. Overhead
Non-manufacturing Costs
Overhead
Marketing
Administrative

16. Classifying Costs for Financial Statements
Matching Concept: The costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.
Period costs: Those costs that are matched against revenues on a time period basis
Product costs: Those costs that are matched against revenues on a product basis.

17. Cost Classification for Predicting Cost Behavior
Volume index
Cost Behaviors
Fixed costs
Variable costs
Mixed costs
Stepped costs
Average unit costs

18. Cost Classifications for Predicting Cost Behavior
By reaction to changes in the level of activity within the relevant range.
Total variable costs change when activity changes.
Total fixed costs remain unchanged when activity changes.
Managers often need to be able to predict how costs will change in response to changes in activity. The activity might be the output of goods or services or it might be some measure of activity internal to the company such as the number of purchase orders processed during a period.
While there are other ways to classify costs according to how they react to changes in activity, we introduce the simple variable and fixed classifications. Just about any cost will change if there is a big enough change in activity. There is some controversy concerning the proper definition of the “relevant range.” Some refer to the relevant range as the range of activity within which the company usually operates or as the range of activity within which the assumptions about variable and fixed costs are valid. Either definition could be used.

19. Types of cost behaviour

20. Fixed Costs
Fixed costs remain the same even if output changes. ( They are costs that must be paid on a regular basis.)
There is a minimum charge for the telephone and utilities that must be paid every month whether they are used or not.

21. Fixed Costs
Definition: The costs of providing a company’s basic operating capacity
Cost behavior: Remain constant over the relevant range

22. Fixed Costs - Example
Damon Company leases its productive facilities for $10,000 per month
Total fixed costs of the facilities remain constant at all levels of activity - $10,000 per month
On a per unit basis, the cost of rent decreases as activity increases and vice versa
At 2,000 radios, the unit cost is $5
($10,000 ÷ 2,000 units)
At 10,000 radios, the unit cost is $1
($10,000 ÷ 10,000 units)

23. Fixed Costs Graphs
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

24. Variable Costs
Variable costs are costs that change with production or sales.
The costs of raw materials increase as more of a product is produced (made).
Labour costs (wages) also increase with production as more workers are needed.
Utility (electricity, water, telephone) costs may increase also.

25. Variable Costs
Definition: Costs that vary depending on the level of production or sales
Cost behavior: Increase or decrease proportionally according to the level of volume

26. Variable Costs
Costs that vary in total directly and proportionately with changes in the activity level
Example: If the activity level increases 10%, total variable costs increase 10%
Example: If the activity level decreases by 25%, total variable costs decrease by 25%
Variable costs remain constant per unit at every level of activity.
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

27. Variable Costs - Example
Damon Company manufactures radios that contain a $10 clock
Activity index is the number of radios produced
For each radio produced, the total cost of the clocks increases by $10:
If 2,000 radios are made, the total cost of the clocks is $20,000 (2,000 X $10)
If 10,000 radios are made, the total cost of the clocks is $100,000 (10,000 X $10)
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

28. Variable Costs – Graphs
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

29. Mixed Costs Costs that have both a variable cost element and a fixed
Sometimes called
semi-variable cost
Change in total but not proportionately
with changes in
activity level
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

30. Fixed Monthly Phone Charge Total Mobile Phone Cost
Mixed Costs
Fixed Monthly Phone Charge
Total Mobile Phone Cost X Y
Total mixed cost
A mixed cost has both a fixed and variable element.
If you pay your mobile phone bill, you know that a portion of your total bill is fixed. This is the standard monthly charge. The variable portion of your phone costs depends upon the number of minutes you consume. Your total bill has both a fixed and variable element.
The graph demonstrates the nature of a normal utility bill.
Activity (minutes)

31. Mixed Costs Y Total mixed cost X Variable Cost per minute
Total Mobile Phone Cost
Variable Cost per minute
The mixed cost line can be expressed with the equation Y equals A plus B times X. This equation should look familiar, from your algebra and statistics classes.
In the equation, Y is the total mixed cost; A is the total fixed cost (or the vertical intercept of the line); B is the variable cost per unit of activity (or the slope of the line), and X is the actual level of activity.
In our utility example, Y is the total mixed cost; A is the total fixed monthly utility charge; B is the cost per kilowatt hour consumed, and X is the number of kilowatt hours consumed.
Fixed Monthly Phone Charge
Activity (minutes)

32. Mixed Costs: High–Low Method
Mixed costs must be classified into their fixed and variable elements
One approach to separate the costs is called the high-low method
Uses the total costs incurred at both the high and the low levels of activity to classify mixed costs
The difference in costs between the high and low levels represents variable costs, since only variable costs change as activity levels change
1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements?
Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases).
Forward-looking Information
Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image).
Timeliness (no real time financial information)

33. Let’s Review - Test Mixed costs consist of what?
a. Variable cost element and a fixed cost element.
b. Fixed cost element and a controllable cost element.
c. Relevant cost element and a controllable cost element.
d. Variable cost element and a relevant cost element.

34. Stepped Costs
Definition: A stepped cost is one that will vary with levels of activity but not directly.
Example: A company may rent a warehouse that is able to store say 100 tons of material. When they reach 101 tons then an additional warehouse is required.
Volume of activity
Stepped costs

35. What is a Variable Costing System?
A cost accounting system which treats fixed manufacturing overheads as a period cost and values stock on hand at the variable cost of production.
Technique/Method of reporting
Internal Reporting
Contribution Concept
Fixed
Costs
I/S
Product
B/S
Variable
Costs
What is Absorption Costing?
Published financial statements

36. What is an Absorption Costing System?
A financial accounting system which values stock on hand at the variable and fixed cost of production.
Technique/Method of reporting
External and Internal Reporting
GAAP, AC108
Fixed
Costs
I/S
Product
B/S
What is Absorption Costing?
Published financial statements
Variable
Costs

37. What is the difference between Variable and Absorption Costing?
Variable costing just takes the variable costs. Fixed Costs are written off as incurred.
Absorption Costing is Variable and traceable Fixed Costs.
Do a quick example.

38. Relevant Costs
Relevant
Irrelevant

39. Identifying Relevant Costs
Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs.
Unavoidable costs are never relevant and include:
Sunk costs.
Future costs that do not differ between the alternatives.

40. Irrelevant Costs Irrelevant cost: not relevant for decision making
Example: Sunk costs: Sunk cost is the cost of abandoned plant less salvage value. Not relevant for decision making.
Imputed (Notional cost): Actually not incurred (interest on own capital, rent on owned building, etc.) Taken into account in capital budgeting decisions.
Replacement cost: Cost of replacing at current market price.

41. Cont…..
Avoidable and unavoidable cost: Cost that can be avoided by eliminating a product or department is avoidable and that which cannot be, is unavoidable.
Ex. – Rent of factory is unavoidable if a product is discontinued.

42. Other costs: Future costs: cost to be incurred in future
Programmed cost: Cost incurred as per policy of top management. Ex.- Donation to charity.
Joint cost: cost of joint or by-products incurred before separation, which cannot be traced to particular products.
Conversion cost: cost of converting raw material to finished goods = Production cost- direct material.
Discretionary cost: not essential for decision on hand. Ex.- Training expenses of workers, R&D cost.
Committed cost: Costs incurred due to past decisions and are not within control in the short run at present. Ex.- Depreciation on Plant, Rent, etc.

43. Costs

44. Fixed and Variable Costs
Fixed / Variable costs
Volume of activity
Cost or revenue
Sales revenue
Variable cost
Fixed cost
Total cost
Break-even point

45. Stepped and Variable Costs
Stepped / Variable costs
Volume of activity
Stepped cost
Volume of activity
Variable cost

46. Assigning Costs to Cost Objects
Direct costs
Costs that can be easily and conveniently traced to a unit of product or other cost object.
Examples: direct material and direct labor
Indirect costs
Costs that cannot be easily and conveniently traced to a unit of product or other cost object.
Example: manufacturing overhead
A cost object is anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects costs are classified two ways:
Direct costs are costs that can be easily and conveniently traced to a unit of product or other cost object. Examples of direct costs are direct material and direct labor.
Indirect costs are costs that cannot be easily and conveniently traced to a unit of product or other cost object. An example of an indirect cost is manufacturing overhead. Common costs are indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.

47. Cost Classifications for Decision Making
Every decision involves a choice between at least two alternatives.
Only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits can and should be ignored.
It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. Costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits are irrelevant and can and should be ignored.

48. Opportunity Costs
The potential benefit that is given up when one alternative is selected over another.
Example: If you were not attending this program, you could save €10,000 per year. Your opportunity cost?
Opportunity cost is the potential benefit that is given up when one alternative is selected over another. These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.

49. Sunk Costs
Sunk costs have already been incurred and cannot be changed now or in the future. They should be ignored when making decisions.
Example: You bought an automobile that cost €10,000 two years ago. The €10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the €10,000 cost.
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this idea into practice.

50. Idle Time
Machine Breakdowns
Material Shortages
Power Failures
The labor costs incurred during idle time are ordinarily treated as manufacturing overhead.
Machine breakdowns, material shortages, power failures and the like result in idle time. The labor costs incurred during idle time are ordinarily treated as manufacturing overhead. This enables the costs to be spread across all the production rather than the units in process when the disruptions occur.

51. Overtime
The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead.
The overtime premiums for all factory workers are usually considered to be part of manufacturing overhead. This is done to avoid penalizing particular products or customer orders simply because they happen to fall on the tail end of the daily production schedule.

52. Problems in Identifying and Measuring Costs
How do I measure the cost of poor quality?
What is the cost of a dissatisfied customer?
How do I measure the cost of setting my price too high?
What is the cost of postponing this year’s training program?